Post Brexit: Managing FX Risks in Three StepsDipak Khot, Head of FX Solutions EMEA and, Gareth Lloyd-Williams, Head of UK Corporate Sales, HSBCThe result of the UK’s Brexit referendum was a shock to many and a stark example of event risk, highlighting the importance of a strategic hedging programme.

Post Brexit: Managing FX Risks in Three Steps

The result of the UK’s recent Brexit referendum was a shock to many, despite polls predicting a knife-edge result. The result itself was a surprise but the market events which unfolded once the ‘leave’ vote was announced revealed some of the most experienced risk management professionals were unhedged against a weaker GBP or out of the money on long GBP exposures. This stark example of event risk has emphasised the importance of a strategic hedging programme rather than a reactionary approach and should prompt many companies to re-assess their existing treasury policies and risk management approach.

HSBC has many years of experience in following the world’s most significant risk events, and a wealth of expertise. The bank is proactive in working with customers to define and implement hedging programmes which combine stability and dynamism to reflect changing market conditions.

Treasurers need to have a hedging programme consistent with their internal treasury policy and such policy in turn has to match the underlying business requirement, this varies from sector to sector or from company to company depending on global exposure.

Step One. Hedge ratios and time horizon

Having defined the hedging objectives, the next step treasurers need to decide is the hedging ratio (i.e., what proportion of exposures to hedge) appropriate for their industry, shareholders’ risk appetite, and the risk management horizon. For instance, a heavy engineering company typically hedges over one to ten years, while a retailer may have a risk management horizon extending from one to six months. Inevitably, the time ‘buckets’ will be quite different in each case, as will the hedge ratio in each ‘bucket’, with most companies choosing to decrease the level of hedging over time depending on the reliability of forecast exposures. For example, a company may choose to hedge 100% of exposures during the following month or quarter, but only 10 or 20% in the sixth month or quarter.

Step Two. Hedging approaches

Once the hedge ratio and appropriate time horizon have been determined, treasurers can decide what style of hedging will allow them to meet their risk management needs most precisely. As figure 1 shows, this can be:

Static (e.g., hedging for a whole quarter at the start of that quarter)

Rolling (e.g., hedging every month for the corresponding month in the following quarter)

Layered (e.g., hedge one third of each month for the following rolling quarter)

Or a combination of all three

These strategies tend to produce a significantly smoother outcome compared with hedging on a spot basis, as they are based on the concept of moving averages but this is not guaranteed. In the example given in figure 2, a static approach results in the greatest volatility, with a layered approach resulting in the least volatility.